Bank bonuses have been blamed for contributing to the crisis, and regulators and politicians are now demanding changes in compensation arrangements. Most of these calls are based on a misconception of the nature of financial risk, an inflated view of the efficacy of risk models, and an incorrect view of the incentive issues facing financial institutions. This column proposes reforms that would discipline senior managers by exposing them to the dangers of junior managers’ risk taking.

The bonus culture in financial institutions encouraged excessive risk taking with implications for financial stability; individual traders enjoyed the upside, leaving the financial institution and even the public to suffer the downside (Sibert 2009, Boeri 2009, Cooley 2009). The regulators have responded with proposals to impose wage controls on banks, evoking the spectre of failed wage control policies of decades past.

How risk taking in financial institutions has changed

Until the 1970s, the predominant institutional form for risk taking in financial institutions specialising in speculative trading was partnerships, with partners’ unlimited liability a central element.

Employees were entitled to bonuses, but entirely at the discretion of the partnership. Employee traders producing significant profits were very well paid; those generating losses did not get bonuses, were often dismissed, and even blacklisted. The partners had a highly developed sense of risk and their asymmetric exposure to it, in no small part because failure could also mean personal bankruptcy.

Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking. Any financial institution engaged in speculated trading faces the inherent danger of individual traders taking so much risk that it threatens the firm. It is the role of the senior management to prevent that.

Bonuses, perverse incentives, and risk

One of the principle concerns with the bonus culture is the divergence of interests between the trader and the firm – a trader maximising short-term revenue causes the firm to assume a significant probability of large future losses.

Trading strategies that show apparent profit in the short term are favoured – a classic example being the writing of out-of-the-money options, receiving regular premiums over a long period of time while being unconcerned about the potential exercise of the option resulting in substantial losses. Corporate bonds or mortgages are a traditional form of this option.

Another is the “Granny-Buster”, a security that pays a marginally attractive rate of interest for a term but fails to repay principal fully in the event of a contingency occurring. Though profitable to the bank, these can result in massive reputational damage and occasionally mis-selling lawsuits. They destroy a central element of sound banking, the investment in goodwill and trust.

The bonus culture has now also permeated other banking activities, far removed from trading. We have seen basic banking activities such as the purchase of long-dated fixed-income assets and their financing with short-term lower cost deposits, subject to bonus compensation for “traders”. These were held on the trading book – when patently it was neither possible nor intended to sell them prior to maturity. Indeed, the fact that an individual employee generates substantial profits for a bank does not in and by itself imply that the employee should receive bonuses.

Problems caused by limited liability for financial institutions

When proprietary trading forms a significant share of total profits in limited liability institutions, it impedes effective risk monitoring as senior management generally does not have the appropriate incentives to restrict risk-taking activities.

The separation of management from equity ownership and liability in financial institutions with significant speculative activities carries several valuable real options for management with incentive-based compensation that can operate to the detriment of shareholders and the public.

If there are neither employment penalties nor significant personal costs associated with having run a failed institution, the senior management has incentives to adopt high-risk strategies for profit, since failure does not mean high personal costs. If these strategies are asymmetric, it may even be in the shareholder’s short-term interest to see them employed. Shareholder quiescence coupled with high annual returns on equity is closely related.

A good example of this is provided by the internal report of UBS into their substantial losses from sub-prime assets (UBS 2008a). UBS relied on a five-year sample and AAA ratings on their super senior positions. The resulting Value-at-Risk numbers were very low for unhedged exposures and often zero for hedged positions.

This poses a number of serious problems. Value-at-Risk is inappropriate for risk analysis in such portfolios and the assumptions in the calculation of Value-at-Risk are generally wrong. The report states that “A consequence of this treatment was a lack of visibility to, and challenge of these positions by, Group and IB Senior Management.” Such senior employees would have been chosen for their financial acumen and would have the resources to independently analyse reports from the CDO traders.

Gaming by a trader can continue even in the face of advanced risk management systems, which rarely capture the length of history necessary to describe the full life cycle of many instruments traded today.

Bonuses, politics, and concerns

Until the crisis, the problems of the bonus culture were not considered a public concern meriting regulation. This has now changed.

The problem of ongoing payments of bonuses in institutions receiving public support lies with the particular manner used to bail out the financial institutions. In their haste to ensure the ongoing business of failed institutions and a desire to avoid taking direct ownerships of the financial institutions, the authorities overlooked the issue of onerous (and indeed sometimes odious) contracts that would continue.

The argument that a bank receiving public support needs to retain the services of these traders, with performance of the contract important, is nonsensical. Losing money, even by bad luck, removes any justification for bonus payments. The most worrying element of this argument is that it suggests a management that believes that the future of banking looks like the recent past.

Would or could the trader leave for pastures greener? Isn’t the trader in precisely the position of Akerlof’s “lemon” – was he unlucky or incompetent?

Calls for wage controls

Politicians around the world have expressed their annoyance with the bonus culture, for example the UK Prime Minister Gordon Brown was “very angry” about bonuses (BBC, 9 Feb 2009).

In turn, regulators and some financial institutions have responded with a host of proposals on reforming the bonus culture. The first, perhaps not surprisingly, came in a report late last year by UBS, a bank particularly ravaged by the bonus culture (UBS 2008b). Early this year, the UK’s FSA (2009), followed by the FSF (2009) and the EU (2009) all floated proposals, with the US expected to follow shortly. A wide range of ideas has been advanced with a strong central element the risk sensitivity of compensation and some form of deferred compensation and even penalties.

Risk-sensitive compensation

The UK’s FSA has proposed risk-adjusting pay, stating “A number of techniques are available to adjust profits and capital for risk, and a firm should choose those most appropriate to its circumstances. Common techniques include those based upon a calculation of economic profit or economic capital.” (FSA 2009)

This rather misses the point. First, risk adjusts expectations, not outcomes – bonuses are paid on outcomes (albeit accounting ones) – “risk” adjusting the outcome would simply be double jeopardy. The problem is that we learn little from the outcome about the risk that was incurred to achieve it.

Suppose we have a high positive return from an event which we knew earlier had low estimated probability of occurrence. Do we attribute this outcome to good luck, good judgement or bad estimation of the exante probability of occurrence?

In any event, risk estimation isn’t even feasible in the case of innovation. By its very nature, innovation introduces uncertainty rather than quantifiable risk.

Let us suppose that risk adjustment might be feasible. The process will require a model which will be a part of the contractual agreement between the trader and the financial institution. The model obviously would have to be open to the trader, who doubtless would resist attempts to improve model accuracy; after all, it is much harder to change employment contracts than internal risk models. This would make gaming a rather simple affair.

There is an evident, growing public discontent among supervisors and regulators with quantitative risk evaluation techniques, including Value-at-Risk and similar methods, so it is surprising to see the same authorities now advocating their use in more doubtful circumstances to risk weight bonuses.

Deferrals and claw backs

The deferral of bonuses for periods of years after award is also being proposed. For example, the UBS report states, “Even if an executive leaves the company, the balance (i.e. remaining bonuses) will be kept at risk for a period of three years in order to capture any tail-risk events.” (UBS 2008b).

Unfortunately, there are some significant difficulties with this in practice. The implication is that the assets or contracts will remain outstanding on the books of the bank, since if the assets, liabilities and contracts have all been liquidated, there is no justification for bonus retention. The departed trader is then in the hands of his successors; it is their success or failure which determines whether or not the full bonus will be paid.

It is necessary to understand who would gain, successor trader or manager, from the lowering of a deferred bonus payment to analyse incentives fully, but the possibility of legal dispute is obvious. The underlying problem is unsolved.

Solving the problem of the bonus culture

The bonus culture is now an embedded market convention – inextricably linked in many peoples’ minds with free and efficient markets. Attempts to dismantle the bonus culture are presented as attacks on this philosophy.

If the bonus culture existed within isolated institutions, it would not pose a systemic threat. But this is not the case, the arrangement is near–ubiquitous and the institutions are closely linked and mutually dependent. It is particularly difficult for a financial institution to defy convention alone; the authorities could assist here with guidance and regulation.

Banking systems of many different types with a great variety of compensation schemes have collapsed throughout history. An ill-thought-out compensation scheme that does not recognise its incentive effects or the limits of risk forecasting is not likely to solve the problems either.

Any regulation needs explicitly to consider its impact on incentives within the bank, both for the most senior management monitoring risk takers and the more junior management more directly engaged in risk taking. This needs to be done in a manner transparent to supervisory review with no obvious avenues for gaming.

Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

The supervisor should have the power and the obligation to impose a lifetime ban from working anywhere within the financial sector, including a nominal unregulated part, for egregious activities. Such powers should be used for managers responsible for financial institutions failing or needing public assistance. For individual traders they should be restricted to breach of limit or risk assessment gaming, especially when bonuses have been retained. This would be a powerful enforcement tool because for most of the trader’s life the future is worth more than the immediate past.

Such an approach will not solve the problem of the bonus culture, but it will give senior management much more incentive to monitor and discipline employees actually engaged in risk-taking and employees will know that breach of risk limits will prove very costly to them.

Conclusion

The bonus culture, created by structural changes within the financial system over the past three decades, was a direct contributing factor to the current financial crisis. Inevitably, given the amounts of public money channelled into the financial system, there have been loud calls for reform of the bonus culture.

Unfortunately, many of the proposals for reform from public institutions would not alter the bonus culture in a meaningful way. Some of the proposals are based on a misunderstanding of the nature of financial risk and advocate methodologies generally rejected within the regulatory system. A veneer of reform merely serves to camouflage these fault lines in systemic stability and that is very dangerous.

Only by directly exposing the most senior employees to the direct downside risk consequences of speculative activities can discipline be brought to bear.